Financial Markets and Institutions (2-downloads)

Federal Deposit Insurance Reform Act of 2005

Merged the Bank Insurance Fund and the Savings Association Insurance Fund

Increased deposit insurance on individual retirement accounts to $250,000 per account

Authorized FDIC to revise its system of risk-based premiums

Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010

Creates Consumer Financial Protection Bureau to regulate mortgages and other financial products

Routine derivatives required to be cleared through central clearinghouses and exchanges

New government resolution authority to allow government takeovers of financial holding companies

Creates Financial Stability Oversight Council to regulate systemically important financial institutions

Bans banks from proprietary trading and owning large percentage of hedge funds

(continued)

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Chapter 18 Financial Regulation

443

2

The full story of the S&L and banking crisis of the 1980s is a fascinating one, with juicy scandals,

even involving Senator John McCain, who was a presidential candidate in 2008. Web Chapter 25 dis-

cusses in more detail why this crisis happened, as well as the legislation in 1989 and 1991 that dealt

with this crisis.

1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

2010

2005

0

50

25

75

100

150

200

Number of Bank

Failures

125

175

225

F I G U R E   1 8 . 1

Bank Failures in the United States, 1934–2009

Source:

www.fdic.gov/bank/historical/bank/index.html

.

The 1980s Savings and Loan and Banking Crisis

Before the 1980s, financial regulation in the United States seemed largely effective

in promoting a safe and sound banking system. In contrast to the pre-1934 period,

when bank failures were common and depositors frequently suffered losses, the period

from 1934 to 1980 was one in which bank failures were a rarity, averaging 15 per

year for commercial banks and fewer than five per year for savings and loan associa-

tions (S&Ls). After 1981, this rosy picture changed dramatically. Failures in both com-

mercial banks and S&Ls climbed to levels more than 10 times greater than in earlier

years, as can be seen in Figure 18.1. Why did this happen? How did a regulatory sys-

tem that seemed to be working well for half a century find itself in so much trouble.

2

The story starts with the burst of financial innovation in the 1960s, 1970s, and

early 1980s. As we will see in Chapter 19, financial innovation decreased the prof-

itability of certain traditional lines of business for commercial banks. Banks now faced

increased competition for their sources of funds from new financial institutions, such

as money market mutual funds, even as they were losing commercial lending busi-

ness to the commercial paper market and securitization.

With the decreasing profitability of their traditional business, by the mid-1980s

commercial banks were forced to seek out new and potentially risky business to keep

their profits up. Specifically, they placed a greater percentage of their total loans in

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Part 6 The Financial Institutions Industry

real estate and in credit extended to assist corporate takeovers and leveraged buyouts

(called highly leveraged transaction loans). The existence of deposit insurance

increased moral hazard for banks because insured depositors had little incentive to

keep the banks from taking on too much risk. Regardless of how much risk banks were

taking, deposit insurance guaranteed that depositors would not suffer any losses.

Adding fuel to the fire, financial innovation produced new financial instruments

that widened the scope of risk taking. New markets in financial futures, junk bonds,

swaps, and other instruments made it easier for banks to take on extra risk—

making the moral hazard problem more severe. New legislation that deregulated

the banking industry in the early 1980s, the Depository Institutions Deregulation and

Monetary Control Act (DIDMCA) of 1980 and the Depository Institutions (Garn–St.

Germain) Act of 1982, gave expanded powers to the S&Ls and mutual savings banks

to engage in new risky activities. These thrift institutions, which had been restricted

almost entirely to making loans for home mortgages, now were allowed to have up

to 40% of their assets in commercial real estate loans, up to 30% in consumer lend-

ing, and up to 10% in commercial loans and leases. In the wake of this legislation, S&L

regulators allowed up to 10% of assets to be in junk bonds or in direct investments

(common stocks, real estate, service corporations, and operating subsidiaries).

In addition, the DIDMCA of 1980 increased the mandated amount of federal deposit

insurance from $40,000 per account to $100,000 and phased out Regulation Q deposit-

rate ceilings. Banks and S&Ls that wanted to pursue rapid growth and take on risky

projects could now attract the necessary funds by issuing larger-denomination insured

certificates of deposit with interest rates much higher than those being offered by their

competitors. Without deposit insurance, high interest rates would not have induced

depositors to provide the high-rolling banks with funds because of the realistic expec-

tation that they might not get the funds back. But with deposit insurance and wide-

spread use of the purchase-and-assumption method to handle failed banks, the

government was guaranteeing that the deposits were safe, so depositors were more

than happy to make deposits in banks with the highest interest rates.

As a result of these forces, commercial banks did take on excessive risks and

began to suffer substantial losses. The outcome was that bank failures rose to a

level of 200 per year by the late 1980s. The resulting losses for the FDIC meant that

it would have depleted its Bank Insurance Fund by 1992, requiring that this fund

be recapitalized. The Financial Institutions Reform, Recovery, and Enforcement Act

(FIRREA) of 1989 (described in Web Chapter 25) provided a bailout of the savings

and loan industry at a cost to taxpayers on the order of $200 billion, 4% of GDP.

This legislation did not recapitalize the Bank Insurance Fund and did not focus on

the underlying adverse selection and moral hazard problems created by deposit insur-

ance. It did, however, mandate that the U.S. Treasury produce a comprehensive study

and plan for reform of the federal deposit insurance system. After this study appeared

in 1991, Congress passed the Federal Deposit Insurance Corporation Improvement

Act (FDICIA), which engendered major reforms in the bank regulatory system.

Federal Deposit Insurance Corporation 

Improvement Act of 1991

FDICIA’s provisions were designed to serve two purposes: to recapitalize the Bank

Insurance Fund of the FDIC and to reform the deposit insurance and regulatory

system so that taxpayer losses would be minimized.

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Chapter 18 Financial Regulation

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3

A further discussion of how well FDICIA has worked and other proposed reforms of the banking

regulatory system appears in an appendix to this chapter that can be found on this book’s Web site at

www.pearsonhighered.com/mishkin_eakins

.

FDICIA recapitalized the Bank Insurance Fund by increasing the FDIC’s ability

to borrow from the Treasury and also mandated that the FDIC assess higher deposit

insurance premiums until it could pay back its loans and achieve a level of reserves

in its insurance funds that would equal 1.25% of insured deposits.

The bill reduced the scope of deposit insurance in several ways, but the most

important one is that the too-big-to-fail doctrine has been substantially limited. The

FDIC must now close failed banks using the least costly method, thus making it far

more likely that uninsured depositors will suffer losses. An exception to this provi-

sion, whereby a bank would be declared too big to fail so that all depositors, both

insured and uninsured, would be fully protected, would be allowed only if not doing

so would “have serious adverse effects on economic conditions or financial stabil-

ity.” Furthermore, to invoke the too-big-to-fail policy, a two-thirds majority of both

the Board of Governors of the Federal Reserve System and the directors of the FDIC,

as well as the approval of the Secretary of the Treasury, are required. Furthermore,

FDICIA requires that the Fed share the FDIC’s losses if long-term Fed lending to a

bank that fails increases the FDIC’s losses.

Probably the most important feature of FDICIA is its prompt corrective action

provisions described earlier in the chapter that require the FDIC to intervene ear-

lier and more vigorously when a bank gets into trouble.

FDICIA also instructed the FDIC to come up with risk-based insurance premi-

ums. The system the FDIC put in place did not work very well, however, because it

resulted in more than 90% of the banks, with over 95% of the deposits, paying the

same premium. The Federal Deposit Insurance Reform Act of 2005 attempted to rem-

edy this by requiring banks that take on more risk to pay higher insurance premi-

ums regardless of the overall soundness of the banking system or level of the

insurance fund relative to insured deposits. Under this act, premiums paid by the

riskiest banks will be 10 to 20 times greater than the least-risky banks will pay. (Other

provisions of FDICIA and the Federal Deposit Insurance Reform Act of 2005 are listed

in Table 18.1 earlier in this chapter.)

FDICIA was an important step in the right direction because it increased the

incentives for banks to hold more capital and decreased their incentives to take on

excessive risks. Concerns that FDICIA did not adequately address risk-based pre-

miums have been dealt with. Remaining concerns about the too-big-to-fail problem

and other issues related to deposit insurance mean that economists and regulators

will continue to search for further reforms that might help promote the safety and

soundness of the banking system.

3

Banking Crises Throughout the World in Recent Years

Because misery loves company, it may make you feel better to know that the United

States has by no means been alone in suffering banking crises both in the 

1980s and then again during the 2007–2009 financial crisis. Indeed, as Figure 18.2

and Table 18.2 illustrate, banking crises have struck a large number of countries

throughout the world since the 1980s, and many of them have been substantially

worse than the ones we have experienced.

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